8 October 2012 last updated

Pension UK annuities may be hit by RPI basis change

The Office of National Statistics (ONS) have begin a review of the way RPI is calculated which could mean a lower level of RPI inflation and lower increases in pension income from UK annuities in payment. In 2011 the government changed the increases in public sector pensions from Retail Price Index (RPI) to Consumer Price Index (CPI) to reduce the future cost of these pensions. It seems that the ONS may now be looking at ways of achieving a similar reduction in RPI escalation and this would have a significant effect on private sector pensions in payment both from employer schemes and personal plans. Other investments affected would the government's National Savings and Investments (NS&I) such as inflation linked saving certificates and index linked bonds. RPI is currently about 0.4% above CPI so any action to reduce the inflation rate will have a long term impact on income.

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Lower RPI will reduce pensioners income

UK annuities can be established with RPI added and at the point of purchase the providers would have assumed a long term expectation of inflation based on this the ONS model. If RPI was expected to be artificially lower in the future then for a given fund the provider would offer a higher starting income. The difference between RPI and CPI has been up to 2.4%.

For example, a single male aged 65 with a fund of £100,000 could purchase an RPI escalating annuity with an income of £3,500 pa. If RPI was expected to be 1.0% less than expected on average in the long term the income paid to the pensioner would be £8,175 lower and applies to those who have already purchased annuities. Once a pension annuity is purchased it cannot be changed as therefore the pensioners would be forced to accept the worse terms of their annuity.

For new customers buying an annuity with RPI it would mean the provider could increase the income paid to £3,850 pa as the cost of RPI to the provider will be less and the annuitant will be better off by £350 pa.

This principle also applies to any employer pension scheme with escalation based on the Retail Price Index. A pension in payment would increase at a slower rate thereby resulting in a lower lifetime income. This also applies to NS&I products such as inflation linked saving certificates and index linked bonds. A lower RPI will make these less attractive to investors which could impact on the government's ability to raise funds.

The difference between CPI and RPI changes over time as the constituents of the indices vary and the Office of National Statistics is looking at three options namely leaving things as they are, small changes to the formula reducing the gap between the indices or a significant change which would mean virtually no gap difference.

This represents risk for pensioners as the basis would be changed after they selecting RPI increases when buying their UK annuities which cannot be changed during their lifetime.